For Bond Investors, Better Safe Than Sorry

With interest rates on long-term bonds as low as they are (the ten-year Treasury note yielded 4.2% in mid November), there's little incentive to extend maturities. And although the economy is weakening, the Federal Reserve may not have the flexibility to cut short-term interest rates any more. It doesn't want to take any steps that could accelerate the dollar's fall -- which, along with soaring oil prices, could fuel a rise in inflation.

One category that looks relatively attractive is tax-free municipal bonds. Munis aren't cheap by historical standards, but they're reasonable compared with today's elevated Treasury prices. "Because of their high-quality nature, they're a good place to hide in today's environment," says Christopher Burdick, of the Schwab Center for Financial Research.

Munis may look even better if the Democrats sweep the 2008 elections. If that happens, higher federal income-tax rates are likely (see Whatever You Call It, It's a Mother). That would make munis' tax-exempt features much more appealing. And if Congress allows the current low tax rate on stock dividends to expire at the end of 2010, a lot of money could shift from dividend-paying stocks into munis, says Lisa More, director of Wilmington Trust Investment Management.

If you'd rather leave the bond picking to a pro, our top tax-free fund pick is Fidelity Intermediate Municipal Income (symbolFLTMX; 800-343-3548). It yields 3.6%, equivalent to 5.1% for someone in the 28% tax bracket and 5.6% for a 35%-bracket taxpayer (for more on tax-free bonds, seeThe ABCs of Munis).

If you want higher yields, a relatively safe choice is a bank-loan fund. These funds buy floating-rate loans made to companies with shaky credit. Although short-term rates have been falling lately -- bad news for a floating-rate fund -- they could bottom out soon. T.J. Marta, bond strategist at RBC Capital Markets, says inflation fears and a falling dollar could prompt the Federal Reserve to push up short-term rates in 2008. A good choice is Fidelity Floating Rate High Income (FFRHX; 800-343-3548). It yields 6.9%, but be aware that it lost 4% of its value in a single month last summer during the subprime-related bond-market turmoil.

The falling dollar also means that investors get a bonus from holding bonds denominated in foreign currencies. Plus, foreign bonds can lower a portfolio's overall risk. Julius Baer Total Return Bond (BJBGX; 800-387-6977) can invest up to 40% of its assets in foreign bonds and has returned an annualized 6% over the past five years.